Beware of Falling Dividends!
U.S. equity markets remain weak as prices of oil and metals continue to drop. Falling demand from a long-term economic slowdown in China has rippled throughout global investment markets.
The S&P 500 is up +0.23% and the Dow Jones Industrial Average is down -1.43% year-to-date through December 8. Unfortunately, folks who own energy stocks have seen their equity portfolios perform more poorly than the market averages this year.
In addition to falling stock prices, I warned investors of the prospect of falling dividends in the energy sector in the October issue of Smart Investing in Turbulent Times. Falling earnings and net losses can disrupt a company’s ability to pay its financial obligations. That’s why I said, “If you depend upon these types of stocks for dividend income to pay your monthly bills, you need to be prepared for the possibility that some of these stocks will cut their dividends during the coming year.”
This month, we saw just such a scenario with Kinder Morgan (KMI). Moody’s downgraded the company, and days later, Kinder Morgan slashed its dividend by 75%.
As a result of the weak commodity markets, the investors who are panicked and selling are currently driving U.S. stock markets, while calmer investors are bargain hunting. Clearly, there are healthy sectors in the stock market, otherwise the S&P and Dow wouldn’t be maintaining breakeven performance this year.
When markets develop unusual scenarios, we can benefit by slightly adjusting our investment approach. While I normally prefer to focus on healthy companies with very bullish stock charts, it’s become obvious that the market is not ready to reward those companies—in the short-term. Therefore, I’m turning my attention to healthy companies with stocks that are trading within low but stable trading ranges, as I did with Abercrombie & Fitch (ANF) in Smart Investing in Turbulent Times in November.
A Tremendously Successful Company with a Bargain Stock Price
Here’s a tremendously successful company that meets all of my growth and value criteria, with a bargain stock price.
Legg Mason (LM) is a U.S.-based global investment management company, with over 2,900 employees. The company operates 16 subsidiaries, including Brandywine Global, ClearBridge Advisors and Western Asset Management.
Legg Mason has a more substantial overseas clientele than many of its competitors. Non-U.S. clients—an actively growing investor segment at Legg Mason—account for 40% of the company’s assets under management (AUM).
In February 2013, the company brought in a new CEO, who proceeded to sell assets, introduce new products and lead the company to improved fund performance. In Legg Mason’s subsequent two fiscal years, the company’s revenue growth outpaced its expense growth, which was a new and welcome trend.
The company’s AUM are expected to grow from $672 billion to about $720 billion by the end of fiscal 2017 (March year-end). The AUM growth is especially strong for Western Asset Management’s global fixed income business, which is successfully taking business away from PIMCO, a prominent institutional competitor. Fixed income investments make up 55% of Legg Mason’s AUM.
Asset growth is important because investment management companies earn money by charging asset management fees, typically a percentage of the principal that clients invest. Despite this year’s poor investment markets, Legg Mason had net inflows of $3.7 billion during its first two fiscal quarters ending in June and September.
Wall Street analysts expect the company’s earnings per share (EPS) to grow aggressively by 40% and 17.8% in 2016 and 2017. In comparison, Bank of America (BAC), Citigoup (C), Fifth Third Bancorp (FITB) and Wells Fargo (WFC) are each expected to grow EPS by less than 10% in 2016 (December fiscal years).
(This week’s Smart Investing in Turbulent Times lists other financial companies that are also well positioned for strong EPS growth in 2016.
LM’s 2016 price/earnings ratio (P/E) is quite low in comparison to its EPS growth rate, at 14.7. In addition, the P/E has reached 19 or higher in each of the last six years; indicating that the stock is currently quite undervalued vs. its normal P/E range.
To put that in perspective, if LM reached a P/E of 19 at some point in fiscal 2016, that would put the stock price at 54.34, representing a 30% increase over the current share price.
minimum annual high P/E x 2016 EPS estimate = minimum 2016 target price
19 PE x $2.86 2016 EPS = 54.34 2016 target price
Legg Mason increased its stock’s quarterly dividend by 25% last spring, from $0.16 to $0.20. The current dividend yield is 1.9%. The next dividend will go to shareholders of record on December 14, to be paid on January 11.
The company repurchased 28% of its shares in the last four fiscal years, and is expected to repurchase another 4% in 2016, and again in 2017. That puts Legg Mason’s repurchase pace near the top of all stocks that I review. A note to newer investors: when there are fewer shares outstanding, the all-important EPS number increases.
Institutions own 89% of Legg Mason’s outstanding stock, which means that professional investment managers consider LM to be an excellent investment.
Buy Now while the Stock Price is Low but Stable
LM shares peaked in 2006, then fell dramatically with the financial meltdown of 2008. The stock then languished for several years. After the company hired its new CEO in February 2013, the stock proceeded to double in the next two years, peaking at just over 59 in February 2015.
More recently, LM has been trading between 41 and 46 since the August market correction, and has not yet begun its recovery. Once LM breaks past 46, there’s additional upside resistance at 49. Barring unforeseen bad news, I expect LM to climb back to 49 this winter, giving today’s investors a potential 16% capital gain. At that time, I would encourage all but the most short-term investors to hold their shares for future growth.
Growth investors, dividend investors, value investors and traders with a several-months timeframe should consider accumulating this mid-cap stock while the price is low.